Risk Latte - “Applause Auction” - Bringing Game Theory to Wall Street

“Applause Auction” - Bringing Game Theory to Wall Street

Team Latte
October 22, 2008

Note: Prof. Avinash Dixit and his students at Princeton economics department are responsible for the invention of the game called "applause auction".

Imagine a thought experiment. Say, Hank Paulson and Ben Bernanke decided to give US$700 billion to nine top banks and investment banks in the United States as "rainy day bonus money". However, this amount will be paid out to the banks through an auction and this gargantuan amount will only go to one bank which wins the auction. In other words, only one out of the nine banks will be the winner and gets to walk away with $700 billion. Also, assume that the erstwhile investment bank, Lehman Brothers is still around and is part of this list drawn up by Paulson and Bernanke.

What is this auction and how will Paulson and Bernanke decide which bank is the winner of the auction? All nine CEOs of the banks will be called to the Federal Reserve Bank (let's say that is the New York Fed) and will closeted in a conference room with Paulson and Bernanke at the head of the table holding a suitcase full of cash. And then they will be asked to applaud. Why applaud? Well, for one, these CEOs are so grateful to the Federal Reserve and the U.S. Treasury for all that they are doing to fix the broken financial system that they can't help but applauding. Whatever the reason, these bank CEOs would be asked to applaud.

The round of applause is expected to be brief (Paulson and Bernanke are both very modest persons) but the prize money of $700 billion will go to that bank whose CEO can continuously applaud for the longest period of time and out do all other CEOs. In other words, the CEO who applauds the longest and keeps applauding when all others have stopped gets the cash.

This is the "applause auction". It is an all-pay auction and the nine top bankers of the United States are bidding in kind, namely "applause", and all of these bidders will pay their bids, win or lose. In this all pay auctions there's no refund for the losers.

So you have the CEOs of Citigroup, J.P. Morgan, Wells Fargo, Lehman Brothers, Morgan Stanley, Goldman Sachs, Wachovia and two others who, desperate for the cash to save their banks and their bonuses, applauding away their lives and the last breath of air in their lungs in a conference room and Paulson and Bernanke nodding in appreciation.

And how long with this round of applause last? Five minutes, ten minutes, half an hour, an hour? And who will applaud the longest? Will it be the greatly enfeebled Vikram Pandit of Citigroup or John Mack, the miracle man of Morgan Stanley? Or, perhaps Lloyd Blankfein of Goldman Sachs will have the enthusiasm and steely nerves to go on applauding when all others have stopped. What about Jamie Dimon, of J.P. Morgan, the man truly on top of things these days? Many of us would be tempted to answer Dick Fuld of Lehman Brothers. In this thought experiment, and just as in real life, Dick Fuld will perhaps do all he can to be the man who applauds the longest to get the cash. Perhaps, he needs it the most.

It is impossible to guess who will be the left applauding the longest and be the winner. And thus it is also impossible to guess as to how long will the round of applause last. Three possible solutions to this problem could be:

  1. Why do whole societies suddenly stop spending and start hording cash when only yesterday they were spending money and consuming all kinds of goods and services like there was no tomorrow.

  2. And the funny part is that even if Uncle Sam comes along and hands you a $100 bill saying,"hey Joe, don't worry, here's a hundred dollars, now go and spend it on that meal that you were planning to skip at the corner steak house"   you may simply pocket that $100 and save it for another rainy and still skip the meal. You are not sure if Uncle Sam will back again on another rainy day.

  3. It is also possible that eight out of nine bank CEOs decide to form gang up on the ninth guy to split the prize money eight ways. They form a cartel to throw out the ninth guy, either the weakest or the most undesirable member of the team. They decide that as soon as the weakest, i.e. the ninth, guy is out they will stop applauding. Then all eight of them will split the prize money. These eight CEOs of banks then keep on applauding in a show of strength, determination and courage. The weakest member, say, Dick Fuld, eventually realizes that he cannot go on - he is either to mentally and psychologically broken or given up all hopes of redemption, and does not have the stamina to keep up with this absurd game and thus he stops applauding and quits game first. All other eight members then stop applauding at the same time and split the prize money.

Well, this is just a thought experiment and interesting solutions to this game are possible. But just for a moment, does it make you wonder the solution number three actually played out in the real world a few weeks ago?

The above thought experiment is adapted from and influenced by the game of applause which actually goes by the name of "applause auction"* and is invented by Prof. Avinash Dixit of Princeton University.

*Reference: http://time.dufe.edu.cn/spti/article/dixit/fungames.pdf

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